Reverse Churning
What Is Reverse Churning?
Reverse churning is a problematic practice within investment advisory practices where an investment adviser charges ongoing advisory fees on a client's account that receives little to no active management or trading activity. This occurs most commonly in fee-based accounts, such as wrap fee programs, where a flat percentage of assets under management is charged regardless of the number of transactions or services provided. The core issue of reverse churning arises when the cost of the fixed fee significantly outweighs the value of the services rendered, potentially violating an advisor's fiduciary duty to act in the client's best interest.
History and Origin
The concept of reverse churning gained prominence as the financial services industry transitioned from primarily commission-based models to fee-based structures. Historically, broker-dealers earned income through commissions on each trade executed. Following the deregulation of commissions in 1975 and the subsequent evolution of fee structures, many firms began offering asset-based fees where clients pay a percentage of their assets under management annually.5
The increased prevalence of reverse churning also relates to regulatory changes, such as the vacating of the "Merrill Lynch Rule" (Rule 202) by the U.S. Court of Appeals for the District of Columbia. This rule had previously allowed broker-dealers to offer fee-based accounts without registering as investment advisers. Its overturning necessitated that advisors register as investment advisers, further blurring the distinction between advisory and brokerage activities and bringing more fee-based accounts under stricter regulatory compliance scrutiny, particularly regarding the value provided for fees charged.4
Key Takeaways
- Reverse churning occurs when a client in a fee-based account is charged ongoing advisory fees for minimal or no trading activity or services.
- It is a concern because the flat fee may not align with the actual services received, potentially leading to excessive costs for the client.
- Regulators, including the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), view reverse churning as a breach of an advisor's fiduciary duty.
- The practice can arise from passive investment strategies, inactive accounts, or a lack of periodic review by the advisor to determine suitability of the account type.
Interpreting Reverse Churning
Interpreting reverse churning involves evaluating whether the fees paid by a client for a fee-based account are justified by the services provided, particularly in light of trading activity and overall portfolio management. If a client's account consistently shows very low trading volume, or if the client's investment strategy is inherently passive investing (e.g., a buy-and-hold approach with only a few exchange-traded funds (ETFs) or mutual funds), a flat percentage fee on assets under management might prove more expensive than a transaction-based commission structure.
The issue is not merely the absence of trades but whether the advisor has failed to provide ongoing advice, monitoring, or other agreed-upon services commensurate with the fee. A crucial aspect of this interpretation is the advisor's fiduciary duty to periodically assess if the current account structure remains in the client's best interest based on their evolving needs and investment profile.
Hypothetical Example
Consider an investor, Sarah, who opens a fee-based advisory account with a financial firm. Her initial client agreement states that she will pay an annual advisory fee of 1% of her assets under management, in exchange for ongoing asset allocation advice, portfolio rebalancing, and regular financial planning reviews. Sarah deposits $500,000 into the account, meaning she pays $5,000 in fees annually.
Over the next two years, Sarah adopts a very conservative, long-term "buy and hold" strategy, making only two small rebalancing trades in that entire period, recommended by her advisor. Despite the minimal trading activity, the advisor continues to charge the 1% annual fee ($5,000 per year, totaling $10,000 over two years). If, during this time, a commission-based account or a lower-fee passive investment option would have cost Sarah significantly less for the same low level of activity, her account might be considered a case of reverse churning. The key is whether the advisor failed to review the account's suitability for the fee structure, given Sarah's actual trading patterns and needs.
Practical Applications
Reverse churning appears predominantly in the context of investment adviser relationships where clients pay recurring advisory fees based on assets under management, rather than per-transaction commissions. Regulatory bodies such as the SEC and FINRA actively scrutinize this practice as a potential breach of fiduciary duty and violations of rules like Regulation Best Interest.
For instance, the SEC and FINRA have taken enforcement actions against firms found to be engaging in reverse churning. A notable example involved Waddell & Reed, LLC, which was charged by the SEC for breaching its fiduciary duty by allowing reverse churning to occur. The firm settled, paying restitution, interest, and civil penalties for failing to adequately monitor its fee-based accounts and ensure the services justified the fees charged.3 Similar enforcement actions have highlighted cases where advisory firms were fined for improperly charging fees on inactive retail client accounts.2 This underscores the regulators' expectation that advisors continuously evaluate whether the chosen account type remains appropriate for a client's trading activity and needs.
Limitations and Criticisms
A primary criticism of reverse churning, from a client's perspective, is the potential for paying excessive advisory fees for services not received or not required by their investment strategy. For clients engaged in minimal trading or pursuing a long-term, passive investing approach, a flat fee may prove more costly than a traditional commission-based account. This can erode investment returns over time.
For financial advisors, avoiding reverse churning requires diligent regulatory compliance and a robust system for periodically reviewing client accounts. Critics argue that the line between legitimate active management with low activity and negligent reverse churning can sometimes be subjective. However, regulatory bodies emphasize the importance of documented communications with clients, regular assessments of suitability, and transparent fee disclosures within the client agreement. Firms that fail to monitor inactive accounts and ensure services justify fees face significant penalties, as evidenced by enforcement actions against those charging improper fees on inactive accounts.1
Reverse Churning vs. Churning
Reverse churning and churning are both forms of financial misconduct, but they differ fundamentally in the nature of the excessive activity (or lack thereof) and the fee structure involved.
| Feature | Reverse Churning | Churning |
|---|---|---|
| Fee Structure | Primarily occurs in fee-based accounts (e.g., assets under management). | Occurs in commission-based brokerage accounts. |
| Activity Level | Characterized by minimal or no trading activity. | Characterized by excessive trading activity. |
| Motivation | To collect ongoing fixed advisory fees without providing commensurate service. | To generate excessive commissions for the broker-dealer or agent. |
| Client Harm | Clients pay high fees for little or no active service, making the fee disproportionate to value. | Clients incur excessive trading costs and potentially unsuitable investments. |
| Regulated Party | Primarily concerns investment advisers. | Primarily concerns broker-dealers and their agents. |
While churning involves a broker excessively trading in a client's account to generate commissions, churning focuses on the lack of activity when a client is paying a flat fee. Both practices violate an investment professional's duty to prioritize the client's interests and can lead to significant financial harm for investors.
FAQs
What are the signs of reverse churning?
Signs of reverse churning include an account with a fee-based accounts structure that shows very few trades over an extended period, particularly if the client's stated investment goals or investment profile would typically require more active management. Another sign is a lack of communication or ongoing advice from the investment adviser despite the regular collection of advisory fees.
Is reverse churning illegal?
Yes, reverse churning is considered a violation of securities laws and regulations, particularly for registered investment advisors. It is viewed as a breach of their fiduciary duty to act in the best interest of their clients, and regulators like the SEC and FINRA have pursued enforcement actions against firms found to be engaging in this practice.
How can investors protect themselves from reverse churning?
Investors can protect themselves by regularly reviewing their account statements and the fees they are charged. They should understand their client agreement and the services they are supposed to receive for their advisory fees. If trading activity is consistently low, or if they feel they are not receiving adequate service for the fees paid, they should discuss this with their investment adviser or consider if a different fee structure, such as commission-based, would be more appropriate for their needs.